Preempting Buffett's Bears

Warren Buffett asked for a Berkshire Hathaway (NYSE: BRK-B) bear to attend this year's annual meeting to lob questions at him and Charlie Munger.

"I just thought it would make it more interesting. The crowd can hear someone who thinks the stock is overpriced, or that it's all a house of cards, or whatever it may be," Buffett said.

Doug Kass, a hedge fund manager and financial writer who is short Berkshire stock, stepped up to the plate. Buffett accepted his application, and now Kass will be in Omaha this May to state his bear case.

"Think of tough questions," Buffett told Kass on Monday. "See if you can drive the stock down 10%."

Buffett can cheerfully -- almost mockingly -- invite a Berkshire bear on stage with him in part because he has little interest in short-term volatility. "Berkshire has gone down 50% four times in its history," he said this week. "When that happens, if you've got money, you buy it." Most CEOs would view their stock falling 50% as a personal failure. Buffett just looks at it as something stocks do from time to time.

I own Berkshire stock, and I think it'll do well over the coming years and decades, but I know it's a fallible company. It has faults. It makes mistakes. Someday, it will make a really big one.

But most of the bearish cases I hear aren't very persuasive. Here's a rebuttal to the common ones.

Berkshire is so big that it's too hard to outperformFirst, not being able to outperform isn't an argument to short a stock. If the S&P 500 returns 9% and Berkshire returns 8%, those shorting Berkshire will lose.

And people have been worried that Berkshire is too big to outperform for literally decades. Buffett first warned his shareholders that size would inhibit returns in 1973. In 1983, he pointed out that Berkshire had earned 22% over the previous 20 years. "Considering our present size, nothing close to this rate of return can be sustained," he wrote. "Those who believe otherwise should pursue a career in sales, but avoid one in mathematics."

Over the next 20 years, Berkshire's book value grew at an average of 24.8% per year.

Despite annual warnings that its size prevents big gains, Buffett has been able to put tens of billions of dollars to work over the last five years at enviable rates of return. Some of Berkshire's most lucrative recent investments, like deals with Bank of America and Goldman Sachs, were accomplished not in spite of its size, but because of it. Berkshire won't earn 25% a year like it used to. But it'll likely earn more than most companies.

Buffett is old. He'll die someday. That will be bad for Berkshire.This is the most rational argument to avoid Berkshire, but I think it's overblown.

Berkshire has almost half a trillion dollars in assets, consisting of everything from Wells Fargo stock to Dairy Queen to jewelry stores to car insurance. Buffett's day-to-day involvement with these investments is virtually nil.

When Buffett dies, Geico won't sell less insurance. Burlington Northern won't haul less freight. American Express won't run out of rich people. Believe it or not, Coke will still taste just as good. The intrinsic value of Berkshire's existing holdings shouldn't change one bit after Buffett passes.

What will change is the company's ability to reinvest earnings as successfully as it has. "There will never be another Warren Buffett," says Kass. He's right, of course.

But don't you think the market knows that? Do you think the market is oblivious to Warren's age and hasn't priced in the possibility of his not-too-distant death? Sorry, it's not that blind. That brings us to the last point.

Berkshire is expensive. The "Buffett premium" will vanish when he's gone.Berkshire used to have a distinct "Buffett premium." It sold at a higher price-to-book value than most of its insurance peers.

But its valuation has steadily trekked downward:

Source: S&P Capital IQ.

Berkshire currently trades for 1.35 times book value. Chubb trades for 1.4 times book. Travelers, 1.2 times book. Progressive, 2.5 times book. Whatever "premium" people refer to isn't clear.

Buffett himself has said he'd use Berkshire's cash to repurchase stock when it fell "demonstrably lower than intrinsic value," which he recently targeted as anything below 1.2 times book -- about where shares traded last month.

I'll stick with his judgment. Good luck, Doug.

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While I agree with the conclusion that the intrinsic value of the existing Berkshire holdings won't budge on the passing of Buffett, I can't agree that the value of Berkshire remains unchanged. A substantial component of Berkshire's value can be attributed to its cash and the expectation that it will be effectively allocated, hopefully with Buffett and Munger as the primary stewards. In a post-Buffett era, a non-Buffett capital allocator will enjoy control over the investment decisions, generating non-Buffett returns (could be better, but likely will be worse). To the extent that this matters (and I'm not certain that it's overwhelming), the value of Berkshire will shift on the death of Buffett and/or Munger.

All that said, Berkshire is probably about fair at this price, but I certainly wouldn't short it (same point as you make, Morgan: shorting a market-performing equity is a losing recipe).